Drop in Unemployment Creates New Inflation Concerns

Inflation is one of the greatest dangers the economy faces. In the past, the Federal Reserve has demonstrated inflation can be difficult to control once prices start to rise.

Because inflation can spiral out of control once it takes hold, the Fed has developed a number of models designed to help forecast potential reversals of inflationary trends. One of the most useful models is based on the Non-Accelerating Inflation Rate of Unemployment (NAIRU). This measure shows the level where unemployment becomes too low. If the unemployment rate is below NAIRU, inflationary pressures on wages increase, and higher wages are a potential source of inflation.

In October, the unemployment rate fell to 5.8 percent, just above the Fed's estimate of 5.7 percent for NAIRU.

Right now, although economic growth is widely perceived to be slow, the data have been telling a different story for the past few months. Declining unemployment is just the latest sign that the economy is actually expanding rapidly. Recessions generally begin when growth becomes "too fast" and it becomes difficult for the economy to continue expanding. We could be reaching that point soon.

If NAIRU falls below the unemployment rate, the odds of a recession rise sharply.

Since World War II, every recession has been preceded by NAIRU falling below the unemployment rate. This has been a sign that the economy is overheating.

On the bright side, this could force the Fed to increase interest rates, an action that would benefit income investors who have suffered with low income for the past few years.